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Oil and price volatility
Dennis Morrison
Wednesday, December 05, 2007
FOR countries that are heavily dependent on imported oil, the sharp retreat in oil prices in the past 10 days must have brought some relief even though OPEC's decision on production levels could affect the market. This is because oil prices fell by about US$10 per barrel in just one week, partly on the expectation that OPEC is likely to raise production quotas at its final meeting for 2007. But it would appear that the majority view within the oil cartel is that supply is not the factor driving higher prices and therefore production quotas should not be increased.
Oil prices had already slipped before the onset of speculation about higher OPEC production quotas. Indeed, the slippage started when data from the International Energy Agency (IEA) and other sources pointed to reduced demand growth for oil. With this confirmation of lessening demand pressure, forecasters became more convinced of the position of the president of OPEC that "fluctuation of prices is a result of several factors that don't have anything to do with market fundamentals". The persistent concerns about the health of the US economy have also reinforced the outlook of a less tight oil market.
What may have made the biggest difference to the oil markets in recent weeks is the perception of a shift in the geopolitical environment in the Middle East. First, there was the resumption of the Israeli-Palestinian peace process, culminating in the conference last week in the USA. After several failed attempts to initiate comprehensive talks, this time around nearly all the key players were prepared to be seen as willing to explore the option of negotiations. Indeed, none of the parties was prepared to invoke a boycott.
Where oil prices were threatening to breach the US$100 mark three weeks ago, the combination of news of a slackening of demand, forecast of a warm northern winter and then the shifting perception of Middle East tensions have led to reduced market pressures. In short order, oil prices slipped to below US$90 per barrel as speculation mounted about increased OPEC production quotas. Yet further price slippage could well occur as news of the US intelligence report on Iran's nuclear programme unfolds.
This programme has been a source of heightened political tension in the Middle East and in Asia Minor, and the dispute over its purpose had become a driver of the uncertainty about oil supply. Thus observers came to recognise this situation as an increasingly important component of risk in the oil markets. But since the US intelligence report now indicates that Iran had in fact suspended its nuclear weapons programme in 2003, we are likely to see a recalibration of the geopolitical risk premium previously embodied in oil prices.
Reflecting on these considerations, the OPEC leaders may adopt a cautious approach to the matter of increased production quotas. If demand growth is easing and oil markets have ample supplies, then the fundamentals of supply and demand would tend to reduce price pressures. Added to these factors, a change in market psychology with respect to the geopolitical risk premiums would further undercut the heightened speculative pressures that were evident in the futures market since August 2007.
Whether OPEC raises its oil production levels or not, the factors outlined above suggest that the upward pressure on prices could be less than has been witnessed in recent months. That would bring a well-needed break for consumers; and in the USA it would be especially welcome at a time when economic fears are running high.
Were the US economy to slip into a recession, there would be further downward pressure on oil prices. Moreover, remembering how prices plummeted in 1997 when OPEC increased output before the Asian financial crisis, the leaders may opt to be cautious about adjusting production levels.
Still, we dare not conclude prematurely that supply disruptions are no more. Even if the supply-demand balance in the oil markets has become less tight, the factors driving price volatility could rebound. And since the US governmental authorities seem set to use monetary and other measures to lighten the impact of the sub-prime mortgage problems, US economic growth could strenghten and with it the demand for oil.
Dennis Morrison
Wednesday, December 05, 2007
FOR countries that are heavily dependent on imported oil, the sharp retreat in oil prices in the past 10 days must have brought some relief even though OPEC's decision on production levels could affect the market. This is because oil prices fell by about US$10 per barrel in just one week, partly on the expectation that OPEC is likely to raise production quotas at its final meeting for 2007. But it would appear that the majority view within the oil cartel is that supply is not the factor driving higher prices and therefore production quotas should not be increased.
Oil prices had already slipped before the onset of speculation about higher OPEC production quotas. Indeed, the slippage started when data from the International Energy Agency (IEA) and other sources pointed to reduced demand growth for oil. With this confirmation of lessening demand pressure, forecasters became more convinced of the position of the president of OPEC that "fluctuation of prices is a result of several factors that don't have anything to do with market fundamentals". The persistent concerns about the health of the US economy have also reinforced the outlook of a less tight oil market.
What may have made the biggest difference to the oil markets in recent weeks is the perception of a shift in the geopolitical environment in the Middle East. First, there was the resumption of the Israeli-Palestinian peace process, culminating in the conference last week in the USA. After several failed attempts to initiate comprehensive talks, this time around nearly all the key players were prepared to be seen as willing to explore the option of negotiations. Indeed, none of the parties was prepared to invoke a boycott.
Where oil prices were threatening to breach the US$100 mark three weeks ago, the combination of news of a slackening of demand, forecast of a warm northern winter and then the shifting perception of Middle East tensions have led to reduced market pressures. In short order, oil prices slipped to below US$90 per barrel as speculation mounted about increased OPEC production quotas. Yet further price slippage could well occur as news of the US intelligence report on Iran's nuclear programme unfolds.
This programme has been a source of heightened political tension in the Middle East and in Asia Minor, and the dispute over its purpose had become a driver of the uncertainty about oil supply. Thus observers came to recognise this situation as an increasingly important component of risk in the oil markets. But since the US intelligence report now indicates that Iran had in fact suspended its nuclear weapons programme in 2003, we are likely to see a recalibration of the geopolitical risk premium previously embodied in oil prices.
Reflecting on these considerations, the OPEC leaders may adopt a cautious approach to the matter of increased production quotas. If demand growth is easing and oil markets have ample supplies, then the fundamentals of supply and demand would tend to reduce price pressures. Added to these factors, a change in market psychology with respect to the geopolitical risk premiums would further undercut the heightened speculative pressures that were evident in the futures market since August 2007.
Whether OPEC raises its oil production levels or not, the factors outlined above suggest that the upward pressure on prices could be less than has been witnessed in recent months. That would bring a well-needed break for consumers; and in the USA it would be especially welcome at a time when economic fears are running high.
Were the US economy to slip into a recession, there would be further downward pressure on oil prices. Moreover, remembering how prices plummeted in 1997 when OPEC increased output before the Asian financial crisis, the leaders may opt to be cautious about adjusting production levels.
Still, we dare not conclude prematurely that supply disruptions are no more. Even if the supply-demand balance in the oil markets has become less tight, the factors driving price volatility could rebound. And since the US governmental authorities seem set to use monetary and other measures to lighten the impact of the sub-prime mortgage problems, US economic growth could strenghten and with it the demand for oil.